Letters of Intent

“LETTERS OF INTENT”(a.k.a. “Term Sheets” and “Memorandum of Understanding”)

What are they? When do you use them?

A letter of intent (commonly referred to as a “LOI”) is often an important “tool” in the negotiation of sophisticated business transactions that ordinarily require significant time, investigation, analysis and expense to arrive at the terms of a definitive agreement. The LOI is often used as a “roadmap” or reminder of the basic terms of a proposed deal so that the parties can proceed with the costly groundwork that necessarily precedes a complex transaction without, in most cases, committing to a binding agreement before all of the details are worked out. In these cases, the LOI is designed to set the stage for further negotiations on the details of a transaction. (Sample terms include, price, definition of assets, due diligence items, financing, conditions of sale, representations and warranties, etc.)

The LOI provides assurances that each side is serious about the deal and willing to negotiate in good faith so that the parties can feel more confident in committing the resources necessary to complete the deal. In less complex deals, the LOI is useful for other reasons, such as to avoid later misunderstandings, to maintain momentum for the deal, or create a sense of moral obligation, if not a legal obligation, to proceed. Sometimes the parties intend to lock in a deal quickly with a more detailed agreement to follow. A buyer may want to bind a target before a competitor enters the bidding, for example, or perhaps the buyer needs a LOI to obtain financing for the acquisition.

Potential Pitfalls

The LOI may create a binding contract! A LOI that is not carefully drafted may impose obligations and liabilities that one or both sides did not intend. In some cases, the actual terms outlined in the LOI may be binding and enforceable. If the court considers the LOI a binding contract, it is an enforceable agreement. You are exposed to enforcement of contract remedies including monetary damages.

In deciding whether a LOI is binding, courts have generally examined:

The language of the LOI;

The context of the negotiations;

Whether either or both parties have partially performed their obligations;

Whether the parties have reached agreement on the essential terms or whether there are any material issues left to negotiate; and

Whether the letter of intent describes a complex transaction that customarily involves definitive written agreements.

In practice, parties to a LOI often intend parts of it to be non-binding and other parts to be binding. Economic terms and similar “business points” are often intended to be non-binding and subject to change based on the outcome of due diligence and further negotiations. Binding terms typically relate to confidentiality obligations, “no-shop” or “standstill” clauses, breakup fees, payment of expenses and termination. Problems arise when the parties do not clearly express which terms are supposed to be binding and which are not.

The LOI may create a contract to negotiate!Â A LOI may impose an obligation to conduct good faith negotiations toward a binding agreement consistent with the terms outlined in the LOI.

In California, the case ofÂ Copeland vs. Baskin Robbins, decided in 2002, established precedent in this regard. In Copeland, the California Court of Appeals imposed liability for the breach, of an implied covenant of good faith and fair dealing on a party who terminated negotiations under a LOI. Even though the Court inÂ CopelandÂ recognized the LOI itself was not a binding expression of the transaction, it did hold that the LOI constituted a contract to negotiate.Â CopelandÂ also recognized that where a contract to negotiate exists, California law will imply a covenant of good faith and fair dealing to the contract negotiations and the party who breaches such a covenant will be responsible for “reliance” (out of pocket costs and possibly lost opportunity costs) damages. The Court reasoned that since business negotiations can be a slow, complex and expensive process, public policy favors protecting parties to a business negotiation from bad faith practices of the other party in terminating the negotiations or making capricious demands.

The following are sample disclaimer terms used to avoid the obligation to negotiate in good faith:

Language disclaiming any agreement to negotiate and explicitly recognizing a right to terminate negotiations for any reason or no reason. Alternatively, a time limitation on negotiations after which either party may cease negotiations for any reason or for no reason may be appropriate;

Language stating that the LOI is nonbinding in the sense of being ineffective to constitute an actual agreement on the subject transaction;

Language specifically addressing each party’s responsibility for costs and expenses incurred in the negotiation and other possible “reliance” damages. In some circumstances it may also be appropriate to address enforcement costs and to specify that the prevailing party is entitled to recover its enforcement costs; and

Language in subsequent correspondence between the parties and their agents reiterating that there is no agreement to negotiate.

Avoiding the Pitfalls of the LOI

The following are some general guidelines to help you avoid unintended consequences when entering into a LOI:

State clearly which terms are binding and which are non-binding. This can be accomplished by dividing the LOI into separate binding or non-binding sections, or by using separate binding agreements to handle matters that must be enforceable, like no-shop/standstill and confidentiality provisions.

Use tentative or conditional language like “preliminary” and “proposed transaction” while avoiding mandatory terms like “shall”, “will” and “must” that suggest an agreement has been reached.

Be careful when making a LOI “subject to” further action. Such language may be construed as creating a valid contract subject to a condition subsequent, which may create an obligation to deal in good faith toward completion of the deal and therefore limit a party’s freedom to simply walk away.

If the LOI is intended to be non-binding, be careful not to require performance that is more consistent with a binding agreement. Usually, performance occurs after an agreement is reached, not during the negotiation period, so requiring certain performances may be viewed as intent to create a binding agreement. Moreover, performance may give rise to a promissory estoppel claim, i.e. Ã¶ one party relied to its detriment on the other party’s word. If a party knows that the other will incur substantial costs in reliance on the letter of intent, that party may be prevented from arguing that the letter is non-binding.

Specify a deadline at which negotiations will end if a definitive agreement is not reached.

Limit the length of the LOI and the level of detail and specify essential terms that have not been agreed upon. A comprehensive LOI that covers most of the essential terms of a transaction is more likely to be held enforceable.

Conclusion

A LOI is a valuable tool in negotiations toward a final contract. However, there are pitfalls which accompany this negotiation tool which you must be concerned with. Each party to a LOI is well-advised to consult legal counsel before signing a LOI that may have serious and unintended consequences for them.